Rewarding processing speed at the expense of accuracy is a failure of risk managment

In the wake of the decision by many leading financial institutions to suspend mortgage foreclosure proceedings due to the discovery of pervasive deficiencies in the way those processes were being carried out, the practices of the banks, law firms, and contractors handling foreclosures have come under increased scrutiny. What has become apparent is that just about everyone involved in mortgage foreclosures — except of course for the mortgage obligees faced with losing their homes — were given incentives to move foreclosures along as expediently as possible, without regard to the quality, accuracy, or integrity of the process. The result of this approach, which really should come as no surprise, was the completion of an enormous volume of mortgage foreclosures, with little or no attention paid to validating the information underlying the process or even to adhering to legal requirements. By rewarding the parties involved for processing speed without regard to accuracy, the mortgage lenders got exactly what they paid for — efficiency at the expense of effectiveness.

The virtually single-minded pursuit of transactional efficiency in mortgage foreclosure processing, and what appears to be its error-ridden result, is reminiscent of some of the fundamental deficiencies associated with other industries and business contexts. Among the more obvious examples is the rampant healthcare fraud related to insurance claims processing, especially insurance provided under the government’s Medicare and Medicaid programs. As a result of years of efforts to drive down the cost-per-transaction in claims processing, the Centers for Medicare and Medicaid Services (CMS) and its claims-processing contractors achieved continuous performance gains in efficiently processing large volumes of claims, but did so in a way that provided almost no protection against fraud, as described in detail in License to Steal, Malcolm Sparrow’s authoritative work on the subject. While many of the core problems that existed in the days (prior to 2001) when CMS was known as the Health Care Financing Administration (HCFA) have been mitigated to some degree, the government’s operation still enables fraud, including systematic fraud on a grand scale, as evidenced by the massive fraud scheme disclosed this week by federal authorities.

Any organization in any sector that establishes an operational approach that prioritizes transaction cost efficiency without taking into consideration the effect of such a strategy on quality (one of several possible ways to measure effectiveness) is likely underestimating the risk — and specifically the business impact — associated with committing to transactions that shouldn’t be processed in the first place. In such organizations, to the extent quality assurance is conducted at all, it is done after-the-fact (in claims processing this is called “post-utilization review”), and long experience across many industries has shown that it is far more costly to try to recover money fraudulently or erroneously paid out than it is to prevent the incorrect payment from going out in the first place. Despite this economic reality, many organizations continue to under-invest in quality controls embedded in transaction processing, often because one side-effect of implementing such controls is slowing down the process.

A key difference between the mortgage foreclosure situation and health insurance fraud is that the banks holding the mortgages being foreclosed have a financial interest in the foreclosures being completed as quickly as possible (whether or not the process is conducted with appropriate rigor), so that the properties may be resold and some proportion of the mortgage obligation can be recovered. In most cases of health insurance fraud, it is the insurer (CMS in the case of Medicare or Medicaid fraud) who bears the loss due to fraudulent payments, and of course as with any government entitlement program, that means the cost is borne by U.S. taxpayers. In the mortgage foreclosure context, it remains to be seen if individuals whose homes were foreclosed upon without the appropriate validation of documentation and other details will have any means of redress, but the mortgage lenders are not the ones suffering financial harm. So, while Congressional hearings and other investigations of the lenders are pending, the individual homeowners who suffered the greatest harm will have to wait and see what action is taken against lenders that allowed or even facilitated improper handling of foreclosures, and whether any compensation will be provided to those individuals.